Income Tax Debt and Chapter 7 Bankruptcy Relief

A common question arises in many of my recent debt relief consultations: How will my income tax debt affect my attempts to completely wipe out my debt, both overall and as to the tax debt itself?

Taxes and Bypassing The Means Test

The first hurdle to proceed in filing under Chapter 7 is the “means test”, which is a formula designed to limit people with higher incomes from seeking Chapter 7 bankruptcy relief. The means test formula uses your last six (6) months’ household income, IRS Data and National Standards to calculate your monthly “disposable income.” While people with debt issues find themselves living paycheck-to-paycheck and regularly borrowing from Peter to pay Paul, many of these same people are often bewildered by the fact that the means test results in, at least on paper, a positive disposable income from which creditors can be paid.

An exception to the requirement of passing the means test to qualify for Chapter 7 relief is if your debts are not primarily “consumer” in nature. Consumer debt is defined as debt incurred for primarily personal, family or household purposes. Good news for people who have incurred substantial income tax debt over the years: most courts consider taxes to be non-consumer debt, even though such debt is almost always incurred for personal, family or household purposes. But who are we to complain about this characterization; bottom line is if your taxes represent more than fifty percent (50%) of your overall debt, you do not have to take the means test to file under Chapter 7.

Discharging Income Tax Debt

Whether your income tax debt is the majority of your debt or not, there are limitations on what income taxes can be discharged/wiped out. Generally, you can discharge/wipe out income tax debt in Chapter 7 bankruptcy only if all of the following conditions are met:

 

  1. The debt is at least three (3) years old. To eliminate an income tax debt, the tax return must have been originally due at least three (3) years before you filed for bankruptcy relief.
  2. You filed a tax return. You must have filed a tax return for the debt you wish to discharge at least two (2) years before filing for bankruptcy. In most courts if you failed to file a return and the IRS filed a substitute return on your behalf, you have not filed a “return” and cannot discharge the income tax.
  3. You did not commit fraud or willful evasion. If you filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, your income tax liability cannot be wiped out.
  4. You pass the “240-day rule.” Your income tax debt must have been assessed by the tax agency at least 240 days before you file your bankruptcy petition, or must not have been assessed yet. Note:       This time limit may be extended if the IRS suspended collection activity because of an offer in compromise or a previous bankruptcy filing.

 Final Note – Slight Twist (Tax Liens)

 Even if you are able to wipe out your income taxes under Chapter 7, you may still end up paying at least a portion of your tax liability. While you will no longer have a personal obligation to pay such taxes, bankruptcy relief will not wipe out prior recorded tax liens against your real estate. The lien will remain on the property and you’ll have to pay off the tax lien in order to sell the property.

Overwhelmed by substantial debt or have any questions about the above topic? The Law Offices of Ian S. Topf, APC offer free consultation in a variety of issues, ranging from bankruptcy, family law/divorce, and estate planning to criminal/DUI matters and landlord/tenant disputes.